Financial Literacy – bank deposit accounts
Or Everything You Ever Wanted to Know about bank interest rates
This article is the second in the series on financial literacy. The first article on spreads can be accessed here.
If you’re like most people on the FIRE journey, you have cash saved in the bank. But have you ever wondered why banks have different interest rates for different products? How do banks even determine what interest rates to charge? And how can you, as the investor, take advantage of that?
This article explains of how different types of savings accounts operate and the factors that drive the interest rates on your deposits.
Difference between a Certificate of Deposit (CD), a Savings accounts and a Term Deposit
First up, savings accounts. Banks offer a variety of different types of accounts for different purposes. Accounts such as checking and transaction accounts are designed for…. as the name suggests…. transactions. But they usually don’t pay any interest. Savings accounts are designed for…. again…. saving money. Hence banks offer inducements and expect the deposits not to move very often.
Term deposits and CDs are different to savings accounts. Basically, both of these instruments are the same. The allow you to deposit a cash in the bank for a fixed term and for a fixed interest rate. They both also have penalties for withdrawing early. The key difference is that CDs are freely negotiable while term deposits are not. That means you can sell a CD before it matures to another party, who then becomes the owner of the CD. Likewise, you can purchase a CD from someone else.
The first thing to understand about how deposit accounts work is to understand yield curves. Quite simply, a yield curve is a given interest rate for each point in time, put into a nice little graph for ease of viewing. Usually, the further out you go, the higher the interest rate you get on your deposit. Below, I have mapped out the interest rates on term deposits you can currently receive from the Commonwealth Bank of Australia (I’m using AUD rates as it looks better than USD rates. Its depressing to lock your money up for 5 years at 0.5%).
You can see that as the term gets longer, you receive a higher interest rate on your deposits. Hopefully this makes intuitive sense. The longer your money is tied up without the ability to access it, the higher ‘reward’ you would want to receive.
Why aren’t term deposit rates offered by banks a smooth line?
You’ll notice in the above rates that certain time buckets have a slightly higher rate of interest than those before or after and a spike at 8 months. This happens due to banks liquidity management requirements. Banks have loans maturing at many points in time. They also have deposits maturing at different times. Banks want to manage this mismatch between loans and deposits to ensure that they have enough liquidity but not too much at each point.
In order to achieve this, banks sometimes offer special rates for certain time buckets in order to attract cash (or liquidity) into those periods.
Alternatively, they may have too many deposits maturing in a certain time bucket and offer high rates to attract people to roll their loans. It’s the job of the banks treasury department to manage that mismatch. As an investor, unless you have need of the money at a certain point in the future (e.g. to make a tax payment), it pays to look around for the best deals.
Why are high interest saving rates often higher than term deposit rates?
The simple answer to that is because of the way bank liquidity requirements operate. Without delving deep into the arcane rules of bank capital requirements, banks have to hold a certain amount of capital for different types of assets. For example, if they hold a government bond, they have to hold 0% capital. But for a mortgage it might be 8% (that is, for a $500,000 mortgage, the bank has to have $40,000 in capital set aside). As banks have to make a certain return on capital for their investors (say 10%), then they have to “make” $40,000 x 10% = $4,000 off the $500,000 mortgage. Hence, one component of the interest they charge.
Likewise, banks have to hold capital for liquidity purposes (liquidity is how easily an asset is turned into cash). The less liquid, the more capital required. When you withdraw cash from the bank, it has to find the money to pay you. When it comes to bank accounts, a savings account is considered to the “permanent” in nature. That is, it doesn’t have a maturity date and hence carries a very low liquidity charge. A term deposit or CD on the other hand has a defined maturity date and hence a higher liquidity charge. If it costs the bank more in capital, then you will get a lower return.
This may seem a little counter-intuitive. You withdraw funds from a savings account at any point in time but you can’t withdraw funds from a CD or term deposit without penalty. However, banks have found that deposits are generally “sticky”. That is, they don’t get withdrawn as often as you might think. Banks also offer inducements such as bonus interest on accounts where a small deposit is made each month.